By Aaron Puthan
Classifying the evolution. I bet Chairman Powell didn’t expect to announce changes to the Fed’s statement of its long-run goals over a video conference from his home office when he was first appointed, but times are strange. The announcement confirms two changes that the market have seen coming:
- The Fed will target an average inflation rate of 2% over time, not just try to get inflation to 2% (a level which some viewed as a ceiling).
- Employment will now be judged on the “shortfall” relative to maximum employment, not the “deviation” from maximum employment. This means that a low employment rate, in and of itself, is not enough to get the Federal Reserve to hike rates.
Back to basics: monetary policy is designed to influence economic cycles by adjusting interest rates. When inflation is low and unemployment is elevated, the Fed lowers interest rates to stimulate economic activity. The idea is to make the cost to borrow low enough that people borrow and invest in assets or enterprises with a higher expected net return than their (now lower) cost of capital (think of buying a house with a lower mortgage rate or taking out a loan to build another laundromat location). This creates spending and hiring, which begets more spending and hiring.
However, as the economy grows, it can start to run out of physical capacity and workers, which causes prices to rise (i.e. inflation). Historically, the Fed would preemptively raise interest rates (lowering the incentive to borrow and invest) to slow down economic growth before inflation became a problem. However, with this recent change, the Fed will be more tolerant of inflation than they have been historically. In other words, they will also be more tolerant of economic growth. This is positive for risky assets across the board.
In the immediate aftermath of the announcement, there seemed to be profit-taking in some of the trades that have been working all summer (Gold, TIPS, USD), which suggests that investors have been pricing in this new, more dovish, structural stance, from the Fed. However, even though some of this change was priced in, the implications of the macroeconomic outlook and all asset classes will play out over a period of years. This gives us an unique opportunity to re-examine views across asset classes after a very good summer for investors.
The U.S. macroeconomic outlook: The Fed’s changes are positive for economic growth over the longer term. It seems likely that the days of rate hikes to preemptively stifle inflation are over. And unless inflation does come roaring back, rate hikes won’t come into play just because employment is full. In the more immediate term, the post-lockdown recovery still looks robust, and consensus expectations for economic growth still seem too pessimistic. Consumer spending on houses, home improvement, and electronics are all impressive and unexpected, and inventories need to be rebuilt. This is a positive for production and trade globally.
The near term outlook still hinges on continued fiscal support, and I still see another fiscal package as likely by the end of September. Importantly, the economic recovery has continued even without control or containment of the virus in the United States. A vaccine would be a welcome development, but the economy may not need one to reach pre-COVID crisis levels. In that scenario, the exposed sectors will suffer (travel, restaurants, leisure, energy), but I think that business and household spending that had been earmarked for those areas will be re-allocated toward lower-risk areas (recreation, home improvement, cloud computing, etc.)
Inflation: I expect inflation will rise gradually as the cycle progresses, but not to levels that would get the Fed to respond with rate hikes soon. Just because the Fed says that it wants inflation to average 2%, doesn’t mean that it actually will. The COVID crisis turned out to be a disinflationary shock (core PCE is at 1.25%), and there are still powerful secular forces that are exerting downward pressure on inflation (globalization, technological advances, lack of labor bargaining power, etc.) However, as the economy continues to recover, demand picks up, and the unemployment rate falls, I would expect inflation to gradually pick up. Remember, some positive inflation is good: more raises, more consumption, more profits.
U.S. short term interest rates: The short-end isn’t going anywhere. U.S. Treasury yields are theoretically the average Fed Fund rate over a given period of time. Right now, 5-year yields are below 30 bps, which means that investors are barely pricing in the chance of a rate hike over the next 5 years. This seems sensible. With the unemployment rate at 8.4% and core PCE inflation at 1.25%, the Fed has a long way to go until we reach maximum unemployment or even 2% inflation, let alone an average of 2%. For investors, this means that cash holdings should be viewed very critically.
U.S. longer-term interest rates: There may be some scope for a modest rise in longer-term rates as the economic outlook improves, but this whole policy change is designed to keep rates of all maturities lower for longer. Since the Fed’s asset purchase program was restarted in March, 10-year yields have stayed within a range of ~50 bps to ~80 bps. Meanwhile, inflation expectations for the next 10 years rose from ~1% to 1.75%. As a result, real yields fell from ~25 bps to ~100 bps. From here, we could expect a slightly higher range for nominal yields as inflation expectations continue to rise (think from ~60 bps to ~100 bps), while real yields stay low. Therefore, the yield curve may steepen modestly.
U.S. Credit: I have seen this movie before. Yield-seeking behavior will drive flows from safer places to riskier places as the cycle proceeds. This time, the Fed itself is even in the market of buying parts of the investment grade and fallen angel space (fallen angels are companies that have dropped from investment grade to high yield). Over the past 20 years, high yield bond’s total returns have been better than stocks. From 2000 through the end of april, they provided 6.5 percent annualized total return, compared with 5.4 percent for the S&P 500. Andrew R. Jessop, manager of the PIMCO High-Yield Fund, says high-yield bonds typically deliver “half the return of equities with half the volatility.”
U.S. Equities: It seems clear that what was once thought of as a bear market rally is a legitimate reflection of the value of secular growth in a world where the only near certainty is low interest rates. In fact, ~¾ of the decline in corporate earnings in Q2 2020, was driven by loan loss provisions from banks, the energy sector, airlines, and other travel related businesses. Companies who are less exposed to physical distance performed extraordinarily well given the circumstances. The change in Fed goals is another support that secular growers will command a premium from investors and should not be ignored, even after an eye-popping rally. The reason: cash flows that happen far in the future are more valuable when discount rates are low.
Meanwhile, cyclical sectors (like industrials and financials) could be attractive, as the momentum from the initial economic rebound continues through the end of the year, having a portion of portfolios in cyclicals could help as medical progress continues. On valuations, the market may seem “expensive” based on P/E ratios, but the earnings yield of the equity market is still well above the average premium to the yield on corporate and Treasury bonds. A reversion of equity risk premiums to their mean means more upside for stocks.
Currencies: Modest weakness is expected from the U.S. dollar. The world’s reserve currency doesn’t have an advantage in terms of yield relative to other safe havens, and the outlook in Europe is looking a bit better given the European Recovery Fund. Importantly, we expect the weakness to come against other developed country currencies and not so many emerging markets. China’s recovery has had the strongest rebound in the world and a quick look at the WB page on Bloomberg shows that one of the few 2y yields above 2% can be found in China. As a result, foreign inflows into China have picked up. Over the past 8 weeks, FX flows into China have averaged their highest levels since 2014. These positive flow tailwinds are one reason why Morgan Stanley analysts claim that increased usage of the Yuan can push it to becoming the third largest reserve currency in the world, behind the U.S. dollar and the Euro.
Commodities: The overall environment supports precious metals, and some industrial commodities could work as the economy improves. Oil is not as impacted. Gold had a fantastic run this summer as real rates fell in anticipation of this change from the Fed. While I think that real rates will probably trend around where they are, gold still deserves a place in a portfolio. Industrial commodities (like copper) could also benefit as the economy improves.
The risks: One risk is that the Fed is abdicating its responsibility for financial stability and will allow an asset price bubble. The Fed has responded to the COVID crisis like it was a generational economic and financial catastrophe, and the formal changes in the statement codify what many have expected: a supportive Fed is here to stay. But if the underlying economy really isn’t damaged (most of the pain has been concentrated in social-distance impacted sectors, bankruptcies haven’t noticeably picked up) and if we get a medical solution soon, we could jump into a mid-cycle environment rather quickly. A strong underlying economy combined with stimulative monetary policy could lead to exuberance and overextension.
This is clearly a risk, but if it plays out, it will probably be measured in years rather than quarters or months. Sentiment is still far from exuberant (Robinhood is not an adequate sample size), household leverage is relatively still low, and debt service costs are manageable. There are still around 10 million workers on the sidelines. Bubbles tend to burst when the Fed pops them. With the recent changes, there doesn’t seem to be the risk of a combative Fed anytime soon.
Another could be a rise in interest rates. The most valuable parts of the equity market, large secular growers, could be at risk if nominal yields move higher. This is a risk, but I believe that the Fed is credible in its commitment to keep rates of all maturities low.
The bottom line is that the post-COVID lockdown recovery is well underway and continues to surprise in the upside. As we continue through the recovery and into expansion, the Federal Reserve has committed to supporting the economy for longer than it has historically. It has already set interest rates well below GDP growth, which stimulates growth, and there is an extremely low risk in the medium-term that this changes. For an economy that is exiting a recession, this should make long-term investors optimistic about the future. Borrowing costs are low. Equity earnings yields are higher than bond yields. Secular trends are being accelerated. Medical progress against COVID-19 is incremental and steady. There is always noise (the election in November is the loudest), but the overall environment seems very supportive to risk assets over the medium term. □
- Image source
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